The Misconceptions and Pitfalls of Options Trading

Options.

They’re supposed to deliver you 1000% returns overnight, week after week right? That’s what a lot of these internet trading “gurus” will tell you anyway…

But the reality is far different.

Options are a zero-sum game. When one person wins, another loses.

The winners are few.

First you have the highly efficient market makers. These guys set market prices through their expertise in the Black-Scholes model used to derive an option’s price. They win in the long-term by controlling risk and collecting the difference in the bid-ask spreads. In exchange, they provide market liquidity.

The brokerage houses win big too. They skim their cut off every trade and come out like bandits.

And finally you have the “sharps” or the professional option traders that squeeze out a profit over time. Their strategy is the hardest to operate. They aren’t rewarded for providing order facilitation services like the other two participants. Instead, they eat what they kill. Over the long haul they can get as rich as the other two, but only if they size up their strategy and/or attract investor money.

So who’s bankrolling these winning players? The suckers.

The complexities of options are not well understood by most of the retail trading world. Nevertheless, they’re highly attractive because of their limited downside, unlimited upside, and embedded leverage. Who hasn’t thought about buying that call option on the hot biotech stock that returns 1000%? Or the way out-of-the money put on the SPY that triples a trading account in a nasty crash? We all visualize that outcome and crave it.

The lucrativeness of the option market drives retail sheep to the slaughterhouse. They don’t know what they’re doing, and so they consistently lose, funding the winners.

For example, most investors think you MUST make a bet on stock’s direction with an options play. But in fact, you can bet on a stock’s volatility with something like a Long Straddle Option Strategy.

You don’t have to be a sucker like these retail traders. Options aren’t magic and they can be used to generate attractive returns. But they need to be used in the right way.

The first step to successfully trading options is clearing up common misconceptions surrounding them.

Misconception #1: Options Can Produce 1000% Returns For Your Account

We’ve seen it all before. And I’m sure you have too. Internet marketers advertising “1000% returns” in a few weeks on a call option. Or they pitch you on some trade idea that will make a 500% return if XYZ stock crashes.

This sounds amazing to uninformed investors whose 401k’s have been clocking in at a measly 4% the last few years. Their greed emotions start to run wild. They tell themselves things like:

“Imagine what 500% or even 1000% returns could do to my portfolio! If I bet $10,000 that could turn into $50,000 or even $100,000!”

Unfortunately these emotional traders set themselves up for disaster.

It’s true that options can 5x, 10x, or even 100x in extreme situations, but these events are rare. And when they do occur, you need impeccable timing on both your entry and exit to realize gains of that magnitude.

The options that can earn huge returns are the “out of the money” options. They have a strike price higher than the underlying for calls, or lower than the underlying for puts. Refer to the option chain for Apple stock below:

At the time of this screenshot, Apple was trading for $97.14. The calls are on the left side of the table and the puts are on the right side. Every option shaded blue is considered “in the money”. Every option shade black is considered “out of the money”. The expiration date for all these options is July 15, 2016. The strike prices are in the middle (the gray area) and to the sides are the prices of each individual option.

Now let’s zoom in a bit and focus on one of these out of the money options.

Check out the 85 puts:

You can see the bid is $.19 and the ask is $.21. To the right of that is the implied volatility (IV) — the option market’s prediction of the underlying’s future volatility. And the next column is the probability that the option will expire in the money. The last column is the delta of the option (the Greeks are a discussion we’ll save for another time).

The marketer’s pitch of 1000% returns on these options isn’t false, it’s just unlikely. The options that 10x, like the 85 put in Apple, can go from $.20 to $2.00, but the probability is extremely low. The option market is only pricing in about a 6% chance of that option making any money at all by expiring in the money. But to get that fat 10x return you not only need the option to expire in the money, you need it to expire $2.00 in the money. That would require Apple to close at $83 by expiration. Apple’s price would have to drop $14.14, from $97.14 to $83. That’s a drop of almost 15%! And all within the next 30 days according to these options’ expiration dates. Trying to hit that scenario reduces your chances far lower than 6%.

Now those emotional investors might argue that their guru KNOWS Apple is going to fall by that much in the next 30 days. The option will definitely finish up 900%. And so they load up their account.

Really???

If a guru could predict a 10x move in an option with 100% accuracy, he would not be telling you about it. Some quick math should leave you highly skeptical. Why? Because even if he started with $10k, he would be a billionaire in just 5 trades.

$10,000 (x 10)

$100,000 (x 10)

$1,000,000 (x 10)

$10,000,000 (x 10)

$100,000,000 (x 10)

$1,000,000,000

And forget 100% accuracy, even if he had 50% accuracy he would be a god amongst market mortals.

A persistent 5% edge in the markets is big. Anything larger is huge. Remember, there are billion dollar casinos that make their nut on a 1-2% edge at the gaming tables.

If you’re playing for a 10x, you would need to be right 10% of the time to break even. (You lose 1 dollar 9 times and on the 10th time win 9 dollars. (9*1)-(1*9)= 0 ) This means a 10% hit rate would give you a 0% edge.

Professional traders would love to get 5-10% edge on an options play over time. To achieve that level of edge you would only need a 15-20% hit rate on options going 10x.

Thinking some investment guru has an accuracy rate much higher than 10% is just fooling yourself. So don’t fall for that. These far out of the money puts and calls are called “lotto options” for a reason. They seldom win, EVEN WITH high quality cutting edge analysis from the best in the world.

But let’s say our guru is actually pretty good and can hit a 10x winner about 20% of the time. His marketing still lures in the suckers because it’s framed in a way that makes you dream about 10x’ing your account on one trade.

This is a huge trap newer traders fall for. The only way to 10x a trading account in one option trade is to go all in. Even a novice student of risk would tell you to never do that. There is a 100% chance of eventually going broke with that strategy.

I (Tyler) play a lot of Texas Hold’em ring games when the markets are closed. (Got to feed the risk addiction somehow.)

The stakes are fairly friendly. Most people buy in with five hundred bucks. Some sit down with a grand.

The people that come to play aren’t students of the game like myself. They consistently lose. But it’s okay because they’re content with “paying” for the entertainment. They’re there for the free food, table talk, and massages from the game girls. If you have any sense of probability or risk/reward, you can consistently extract money from this pool of players. It’s a fun way to earn a side income. (The cross-training between trading and poker is also incredible, but that’s a topic for another day.)

Anyway, the same guys who come to the poker tables every night to blow off steam are also the ones going all in on options plays. To them, trading is just another outlet for gambling.

I can’t tell you how many stories I’ve heard at the poker table of guys who’ve taken their $20,000 trading account to $100,000 in a year and then wind up broke. They lose it all. Every single penny.

But this never surprises me. Over leveraging and going all in might make for a good story at the poker table in the short term, but it always ends badly. You can’t fight the probabilities no matter how hard you try.

If you plow all your money into one trade, you will go broke. If it doesn’t happen this trade, it’ll happen the next one. It’s important to think of trading as a long-term process rather than a single hot tip. True wealth is made by long term compounding, not a one off gain from some option trade.

So when the marketing gurus tout 1000% returns, keep in mind that it’s just a one off trade that you can’t put your whole account into anyway.

At Macro Ops we’ll usually bet .5% – 2.5% of our account on any one trade. A lot of hedge funds will even bet as low as .10% per trade.

If you follow sound position sizing mechanics and put 1% of your account into the guru’s pick and get your 10x, your total account would be up 10%. Now don’t get me wrong, that’s a great return since you only took 1% risk to get it. But it’s a far cry from a 10x on the whole wad.

Misconception #2: Options Are More/Less Risky Than Stocks

The financial media will tell you that options are more risky than plain vanilla stocks. This is true if we define risk as the volatility of returns. But practitioners will tell you that volatility is a crappy measure of risk.

Other market participants will tell you the opposite. They claim options are far less risky than stocks because your loss is defined. This sounds good on paper, but in practice it’s not too important in an overall risk management system.

Both these viewpoints on option risk are wrong.

Options are neither more or less risky than stocks.

Risk is a function of position sizing, not product type.

Let’s break it down.

As an investor or trader you always want to think of your downside in relation to your account size.

Say you want to buy a call option because you think the price of a stock will go up. You have a $100,000 account. There’s a chance that call option expires worthless and 100% of your invested capital is lost. But you get to choose what that 100% loss means in relation to your account.

If the call costs $1.00 you could bet your whole account and buy 1000 of them. In that case if the option expired worthless, you’d be broke, having lost the 100 grand. Now say you bought only 1 call option for a total of $100 and the option expired worthless. A loss of $100 on a $100,000 account is only a 0.10% loss in total.

So you see the option is not inherently more or less risky than the underlying stock. It just behaves differently.  Rather, what makes it risky is the number of calls you buy.

This same argument is also used against sellers of options. Critics say “well if you sell a naked put you have limited upside and unlimited downside. That’s a very risky position.”

Again, the short put is not risky in and of itself. It’s risk depends on how many you sell.

For example, say you had the choice between buying shares of SPY the S&P 500 ETF or selling a put on the ETF.

Let’s say the stock is trading at $206.44 and a 206 put is selling for $4.45.

If you bought 100 shares of the stock, you would spend a total of $20,644. Now imagine the market got knee capped and SPY sold off 50%. You would be sitting on a $10,322 loss.

On the other hand, if you sold one of those puts struck at 206, with the same 50% decline in the market, things would play out differently.

After the 50% drawdown SPY would be trading for $103.22. The puts are in the money and you owe the buyer (206 – 103.22) * 100 or $10,278. But don’t forget, you also received that original $445 credit at the time of sale. So the net loss would only be (10,278 – 445) or $9,833. You actually lost less than if you had just bought the plain vanilla stock!

In this scenario selling one put option was less risky than buying plain vanilla stock.

Now say you were feeling greedy and sold two puts instead of one to collect $890 in credit. And imagine the 50% decline still occurred. Instead of a $10,278 loss, you would have to cover a $20,556 loss. Subtract the credit of $890 and you’re left with a net loss of $19,666. This is MUCH larger than the $10,322 loss on the 100 shares of plain vanilla stock.

See the difference? The riskiness of the put has to do with position sizing, not the nature of the instrument.

False beliefs regarding risk can be very limiting to your development as a trader or investor.

Remember: position size determines risk… NOT product type.

Now that we’ve cleared up some incorrect assumptions associated with options, let’s discuss the downsides to options no one ever mentions.

The reason no one talks about these pitfalls is that it’s against the system’s best interest. The system wants retail traders churning their accounts at brokerages with tons of options trades. The more trades the better.

Brokers earn fat commission fees and their affiliates that market for them get a nice cut too. Market making firms make a killing from the large retail order flow. And programs like CNBC can garner audience engagement by fascinating the public with their “sophisticated” options trades.

But understanding these pitfalls are key to ensure your success in the options market.

Pitfall #1: False Confidence And The Folly of Sophistication

False confidence in anything is dangerous. This is especially true in options trading. It’s a silent killer that leaves its victims demoralized and broke, slamming drinks at the local bar, wondering where it all went wrong…

So how does false confidence infect an option trader’s mind?

It starts when an investor first learns about the plethora of option spread trades available to him. These spreads have a bunch of cute and fancy names, making them all the more interesting at first glance.

You’ve probably heard of some of them:

• Put spreads
• Call spreads
• Vertical spreads
• Iron Condors
• Condors
• Butterflies
• Iron Butterflies
• Straddles
• Strangles
• Calendar Spreads
• Ratio Spreads
• Back Spreads
• Covered Calls
• Diagonals
• Double Diagonals
• Combos
• Collars

And the list goes on…

The option “gurus” tend to whip up new ones year after year too, just to hold the interest of unsuspecting investors and traders.

Now we’re not going to go into the nitty gritty of what each of these are. Most of them are bullshit and don’t matter unless you’re an options market maker anyway. But that doesn’t stop average retail traders from getting sucked in.

When they first start, they get excited about figuring out what these different spread trades are. And after they can finally recite them from memory, they start to think they know something.

This is where the danger begins.

These spreads are very complex. Just knowing what they are is not enough to successfully use them. But novice traders don’t realize this. Instead, they mistake their basic understanding of options spreads as skill and start to fire off trades like mad men.

I know this because I did the same in the very beginning of my options trading career.

Sophistication and complexity do not imply an edge.

In trading the opposite is usually true. A simple process is more likely to have persistent edge than a complex process. Don’t confuse the fancy structure of these option spreads with an actual edge in the markets. Just because something is complicated, doesn’t mean it will make you more money. In fact, you may wind up losing your shirt instead…

Pitfall #2: Commission Intensity

Why are all those spread structures that we mentioned above mostly worthless to retail traders?

Because all they do is run up commissions and add next to no value.

The primary goal of a spread is to hedge or reduce your exposure. You’re not really trying to add anything new to your book with this strategy. But novice traders don’t understand this. They try to place bets with spreads anyway.

And of course the brokers never mention this — they’re too busy getting rich off the fees.

Take the bull call spread for example.

The bull call spread is constructed by purchasing one call and then simultaneously selling another call at a higher strike. Buying the first call gives you exposure to the underlying price going up. But selling the second call gives exposure to the underlying price going down. These two positions clearly contradict themselves if you’re trying to bet on direction.

Consider a 208/210 call spread in SPY.

The 208 call is trading for $3.25 and the 210 call is trading for $2.18. You can buy the 208 call and sell the 210 call for a net debit of (3.25 – 2.18) or $1.07.

The maximum total value this spread can reach is $2.00. (Width between the strikes of 210 and 208.)

The maximum amount of profit you can make on this trade is ($2.00 – $1.07) * 100 or $93. The max you can lose is $107, or the cost of the spread.

Since a vertical spread consists of two options, you have to purchase two contracts to complete the trade. Using a standard commission rate of $1.00 per contract would cost you $2.00 in total.

Spending $2 in fees to make $93 is terrible. This may be hard to see at first. But add in a realistic win rate on this trade of 60% and it becomes clear.

The win rate can be used to calculate the breakeven rate which comes out to 53.5%. So we’re giving ourselves a hefty 6.5% edge (60 – 53.5).

If this trade played out 10 times with that 6.5% edge, it would look something like this:

Trade 1: -107

Trade 2: 93

Trade 3: -107

Trade 4: 93

Trade 5: 93

Trade 6: -107

Trade 7: 93

Trade 8: 93

Trade 9: 93

Trade 10 :-107

Total Profits: $558

Total Losses: $428

Gross Profits: $130

Commissions: $20 (2 dollars a trade times 10 trades)

Net Profits: $110

Commissions cut over 15% from your bottom line! And that’s with a cheap commission structure, strong edge, and an assumption that you let the spread expire. If you exit the trade before expiration, that will rack up another 2 dollars per trade, bringing total commission costs to $40. That only leaves a net profit of $90 — an over 30% reduction to your bottom line!

You can see how these commissions add up. A cost structure this high will send even a highly skilled trader to the poor house.

The economics get even worse as you tighten the option spread (use strikes closer together) or add in even more legs (a leg refers to one part of a spread). Some option spreads require 4 legs to execute!

You can spend far less in commissions on a futures contract or outright stock trade for much larger upside.

Pitfall #3: A Zero-Sum Game

Another important “hidden” risk to understand about options is that they’re derivatives and therefore a zero-sum game. (Negative sum when commissions and the bid ask spread are included.)

This means that whenever you take a position, someone else is taking the other side. That other person could be a retail trader, bank, commercial hedger, market maker, HFT firm, or professional proprietary trader. If you win, that other person loses. And if you lose, that other person wins. It’s a constant battle of wits between market participants. And of course the middlemen take their cut along with Uncle Sam after it’s all said and done.

With stocks and bonds the story is a little different. It’s not necessarily a zero-sum game. The pie can theoretically grow so every investor wins.

When you’re invested in a company, you’re entitled to a portion of its assets and a portion of its income through dividends. All holders of the company’s stock win if it sells more widgets and earnings grow. You can theoretically get paid higher dividends while the assets you hold become more valuable.

Look at the Dow since the early 1900s. Everyone was a winner as long as they held stocks long enough.

The same thing is true for long term holders of sovereign bonds. An investor gives his money to the government and over the course of 10 years or so he receives his original investment and then some. The government wins from the financing it receives. And the investor wins because his cash earned some extra income.

So before you fire off that next option trade, remember: it’s you against them. Someone will lose. And you’re usually playing against a professional operator who relies on making profitable option trades to feed his family.

When framed in this context, the amount of trades I took in the options market plummeted. It’s a matter not to be taken lightly.

Hopefully this discussion has cleared up a lot of the false advertising and BS claims out there. With this basic understanding of the misconceptions and pitfalls of options trading, you’re ready to move to the next step — understanding and trading option volatility. We created a special report covering this very topic. You can check it out here.